Thursday, May 31, 2012

Higher, faster, longer. With the Olympics and the European Soccer Championships, Europe will once again celebrate these superlatives, enjoying the race for the gold medal. However, when looking at the Eurozone, these superlatives remain limited to sports. The economic outlook looks rather dire and will take a lot of time before superlatives return into the economy.

There is no quick fix for the Eurozone sovereign debt crisis. Most Eurozone peripheral countries have been surfing on a debt wave during the first ten years of the monetary union. Sometimes it was a public sector debt wave (Greece), sometimes a private sector debt wave (as in Spain or Ireland). Other countries did not even experience the pleasure of surfing at all but have been suffering from increased competition from emerging markets, thereby pushing the economies into sluggish growth (Portugal and Italy). The global financial crisis has brought an abrupt end to these smaller and bigger pleasures.

The only way forward is to reform economies, deleverage public and private finances and to bring the economies on a more sustainable footing. Contrary to what some observers sometimes claim, there is no alternative to austerity measures. With ageing societies and interest rate payments often the second largest expenditure post in national budgets, the principle necessity of austerity should not be discussed. The short history of the Eurozone has actually shown that good times have hardly ever been good enough to start big-shot expenditure cuts. As consequence, fiscal austerity will have to be part of the economic game in the Eurozone in the coming years.

Of course, austerity measures push the Eurozone peripheral even further into a vicious circle of reforms, recession and reduction of debt. Double-digit unemployment rates and youth unemployment close to 50% in countries like Spain and Greece is the best illustration of how painful the so-called economic adjustment will be. But is there an alternative?

It is often said that core Eurozone countries should simply spend more, increase domestic demand or even engage in direct transfers to help peripheral countries growing again. This is easier said than done. At the current juncture, core Eurozone countries are not very likely to be able to alleviate peripheral pain as most of them also have to implement austerity measures and are not free of concerns. For example, the Netherlands still has to cope with a creeping process of deflating of a real estate bubble. France, the second largest economy of the Eurozone, will have to implement structural reforms to regain international competitiveness. Even the last economic stronghold, Germany, is facing more difficult times as export demand from both outside and inside the Eurozone has been weakening. Latest positive wage developments could quickly turn out to be a flash in the pan. Moreover, as Germany is an ageing society, the hope for more domestic consumption and less savings could easily fall on deaf ears.

With such a bleak outlook for the Eurozone, the quest for growth has become increasingly popular. However, even the best growth compact can only be a supplement not a substitute for structural reforms and austerity measures. The effect of more European investment in countries with rather too many than too little investments over the last years is questionable. It would also do little to stop Spanish housing prices from dropping or unemployment from rising. Traditional Keynesian recipes might have worked in economies or sectors, which were structurally healthy (e.g. the German car scrap scheme), but their scope should be very limited when the problem is of a structural nature. Of course, the Eurozone needs growth and there is more to the crisis management than only austerity. However, a new Eurozone growth compact should only be the sweetener for the unpalatable austerity and reform medicine not an entirely new crisis treatment.

Whatever the Eurozone will try, there is no silver bullet to solve the current crisis. The short-term prospects for the Eurozone look anything but rosy. The Greek drama is approaching a new climax, more bailouts look probable, more debt restructurings cannot be excluded and as a result of all of this growth will continue to disappoint. Therefore, it is time to come up with a master plan for the future. The vision thing. Such a master plan could re-invent the Eurozone’s economic model, identify new sources of growth, commit to the goal of sustainable public finances, but also come up with a clear and binding roadmap towards more integration with at the end of such a process possibly a common Eurozone bank supervision, a bank resolution scheme and even Eurobonds.

All top athletes know that winning a gold medal is the result of years and years of practicing. Champions are not made overnight. If the Eurozone economy wants to compete again for a gold medal in the global race for economic top performance, it will require at least three qualities from Olympic athletes: a good plan, hardship and a lot of stamina.

Yesterday, the European Commission showed that the austerity-based approach is more flexible than some might think.

Yesterday was a big day for the European Commission. On one single day, the Commission tried to show that the new, more European, fiscal framework could work, while at the same time keeping the initiative in the race towards a more integrated monetary union.

In its regular assessment of national fiscal plans and reforms, the European Commission showed that the Eurozone’s fiscal framework is not as strict as many often think. The Commission opened the door for Spain to get an additional year for reaching its deficit target, applying the so-called exceptional circumstances. However, the Commission said that two conditions had to be met first: Spain needs to submit a solid plan on how to bring the deficit back to 3% of GDP by 2014 and get excessive spending at the regional level under control. This confirms our broader view on the Eurozone’s fiscal framework, i.e. that under “exceptional circumstances” the consolidation path can be extended, if governments in question show their long-term commitment and determination for sustainable public finances.

Still, the big litmus test for the European Commission and the Eurozone’s fiscal framework is still to come and it will not be about Spain but probably about France. Will exceptional circumstances remain exceptional or just the new paraphrase for leniency. According to the official Commission forecasts, France’s fiscal deficit will be at 4.2% of GDP in 2013, still far off the required 3%. Contrary to other governments, like for example the Dutch government, the French government has so far refrained from additional austerity measures, rather claiming that the Commission’s growth forecasts for France were too pessimistic. Yesterday, the Commission gently reminded France that it had to take “effective action” in order to reach the 3% target next year. The Commission is obviously willing to talk the talk but only time will tell whether it is also willing to walk the walk.

Also yesterday, Commission president Barroso showed that the Commission wants to play an important role in the discussions on how to deepen integration in the monetary union. It is only a thumb sketch, yet, but Barroso presented building blocks to take the Eurozone towards a full economic union. These building blocks could include, among others, a banking union with integrated financial supervision and single deposit guarantee scheme and, as already known, common Eurozone bonds. Even if it would take a lot of time before these elements could actually become reality, the Commission’s proposals go into the right direction and could be an important contribution to the “vision thing” for the Eurozone.

All in all, yesterday did not change the situation in Spain and Greece. However, on a somewhat more positive note, yesterday’s events could have been another small step into the right direction, showing that the austerity approach is more flexible than some might think.

German unemployment dropped by a non-seasonally adjusted 108,000 in May, bringing the number of unemployment to the lowest level since December last year. However, this is the weakest May improvement since 2002. In seasonally-adjusted terms, unemployment remained unchanged, bringing the seasonally-adjusted unemployment rate down to 6.7%, from 6.8%. Earlier today, German retail sales, adjusted for seasonal effects and inflation, were up by 0.6% MoM in April. The second consecutive increase.

At first glance, today’s numbers illustrate the strength of domestic demand, at least partly cushioning the German economy against the negative impact from the debt crisis. At second glance, however, signs are increasing that the resilience of the German labour market is slowly cracking up. The non-seasonally adjusted improvement in May was already much weaker than one year ago and actually the weakest May-improvement since 2002. Moreover, recruitment plans have been further downscaled. In May, the European Commission’s index for employment expectations in the German manufacturing industry turned negative for the first time since July 2010. Interestingly, the official vacancy index, BA-X, increased in May, stabilising at a level close to historical highs. The combination of weakening recruitment plans and high vacancies shows that the German labour market has probably reached a level close to its natural unemployment rate. Further significant drops of unemployment would require new structural reforms.

The German labour market is losing momentum but this is not yet a cause for concern. At least not for this year. With a new boost from latest wage settlements, domestic demand might not be a strong, but definitely an important, growth driver.

Thursday, May 24, 2012

New realism? Today’s Ifo index shows that German businesses have finally lost their optimism. In May, the Ifo index dropped to 106.3, from 109.9, the sharpest drop since August last year. Both the current assessment and the expectation component dropped sharply. The current assessment component fell to its lowest level since July 2010.

Until recently, it seemed as if the German economy had turned into an island of happiness. The Ifo had defied all Eurozone crisis woes for more than half a year and growth returned strongly in the first quarter. Germans who in the past had often been called “Angst-savers” have all of a sudden become a bunch of happy-go-luckies. In a recent study, Germans turned out to be a people of optimists with a huge majority expecting their lives to turn to the better in the coming year. Today’s Ifo index, however, is a clear signal that even the new German magnificence could come to an end.

With austerity-driven slowdowns coming to most other core Eurozone countries, an obvious cooling of the Chinese economy and a still not very dynamic US recovery, export growth should clearly come down. Moreover, hopes for more domestic consumption on the back of higher wage could easily be disappointed when exporters see market shares dropping. In our view, the wage settlements this year are rather one-offs than the start of a new trend.

Despite the impressive growth comeback in the 1Q12, our outlook for the German economy remains more nuanced than during the last two years. The exuberance of 2010 and 2011 has made room for more realism and lower expectations. The economy will continue to grow but at significantly lower pace.

For last couple of months, it had seemed that the Ifo index painted a too positive growth picture. Today’s Ifo reading has corrected this picture in one fell swoop. German businesses have woken up to reality: islands of happiness might exist, economic islands within the Eurozone hardly.

Wednesday, May 23, 2012

As expected, last night’s dinner for European leaders did not yield any concrete results. The quest for growth and a broader vision on the Eurozone’s future continues.

Yesterday’s informal Summit of European leaders will not make history as a breakthrough for Europe or the Eurozone. As expected, it was only a stopover on the way towards the June summit. According to European Council president Herman van Rompuy after the meeting, European leaders are on a good way to adopt a growth compact in June, probably along earlier lines of more European funds, investment projects and structural reforms. It is obvious that a June growth compact will be a compromise with which both the austerity and spending supporters can live, illustrated by Van Rompuy’s statement that “opposing deficit reduction and growth is a false debate. They are two sides of the same kind.”

While a growth compact is in the making, all other broader issues remain highly controversial. Issues like common Eurobonds and a common European bank deposit insurance scheme were apparently mentioned yesterday but without any progress. At the same time, however, leaders agreed on the need “to take Economic Monetary Union to a new stage” and to “strengthen the economic union to make it commensurate with the monetary union.” Van Rompuy’s statement that he would report in June on “the main building blocks and on a working method to achieve this objective” shows that these issues will not be part of the growth compact in June. The “vision thing” has once again been postponed.

While the Eurozone is still searching for growth, Germany has it. Today’s second estimate of German 1Q GDP growth confirmed an excellent growth performance. The German economy grew by 0.5% QoQ, from -0.2% QoQ in 4Q 2011. Compared with 1Q 2011, the economy grew by 1.2% (seasonally and working-day adjusted).

Today’s release also presented the growth decomposition, showing that the growth comeback was mainly driven by private consumption(+0.4% QoQ) and exports (+1.7% QoQ). The drop in inventories, however, was a clear warning signal for the growth in the coming quarters, reflecting weakening new orders.

Growth in the Eurozone's biggest economy, especially when it is domestically-driven, should be beneficial to the rest of the Eurozone. This is at least a common economic wisdom and often presented as a basic principle for a rebalancing of the Eurozone economy. However, the reality looks less encouraging. German trade data of 2011 show that hardly any Eurozone peripheral country has benefitted from the German growth miracle. While total German imports increased by around 13% YoY in 2011, imports from Greece and Spain were only up by roughly 2% and imports from Ireland were even down by roughly 7%. Only Portuguese exporters seem to have benefitted from the German recovery.

The German economy has avoided a recession and staged an impressive growth comeback. The rest of the Eurozone, however, will have to continue its quest for growth.

Tuesday, May 22, 2012

European leaders will meet for an informal dinner tomorrow evening to prepare a growth compact. Firm decisions will probably not be taken, but the pressure on Angela Merkel is likely to increase.

European Council president Van Rompuy has invited European leaders to a dinner party tomorrow evening in Brussels to prepare a common strategy to boost economic growth in Europe. Van Rompuy wants leaders to sign off on a new growth pact in June, which is expected to include a €10bn capital boost for the European Investment Bank, the launch of a series of 'project bonds' to fund key investment infrastructure – backed by the EU budget – and the possibility of reallocating unspent EU Structural Funds to needy countries. It appears that, in recent weeks, a discrete consensus on such a European growth pact has already emerged. Even the expected German opposition has been relatively mild. Clearly, such a growth pact or compact would be in addition to the fiscal compact that commits countries to balanced budgets and more-sustainable public finances.

Even a consensus on the growth compact seems to be emerging; however, this is not where tomorrow’s dinner will stop, enabling everyone to jauntily enjoy the dessert. More controversial issues are also likely to be discussed, potentially leading to stomach upset. Some of these issues are the difficult task of how to resolve problems in Spain’s financial sector and a possible role for the ESM in direct bank recapitalisation.

Clearly, Van Rompuy wants to stimulate a more-fundamental discussion on the future of the Eurozone, beyond the current crisis management. “It is not too early to think ahead and to reflect on possible more fundamental changes within the EMU,” he said. “In many ways, the perspective of moving towards a more integrated system would increase confidence in the euro and the European economy generally.” Clearly, such a discussion does not come too early; let us hope it does not come too late. With a clear vision for the future of the Eurozone in mind, it could be easier to find the right answers to the current crises.

In the context of this more-fundamental discussion, it is interesting to note that tomorrow’s dinner will be the third encounter between German chancellor Merkel and France’s new president Hollande within slightly more than a week. It is still a relationship in the making, illustrated by the fact that commentators have trouble finding a catchy portmanteau like ‘Merkozy’. First ideas, such as ‘Merk-ande’, ‘Fran-gela’ or ‘Mer-de’, have clearly failed the test. Hollande does not seem to tire of pushing forward his ideas of a common Eurobond, and the number of potential allies is increasing. However, even at the risk of falling into European isolation, German chancellor Merkel still looks very resistant to the idea of Eurobonds. At least for now. Ideas for a product like debt redemption funds are gaining increasing popularity in Germany. However, in our view, chancellor Merkel would only be willing to accept any kind of common Eurobond if and when moral hazard can be ruled out. For this, fully-fledged ratification and implementation of the fiscal compact should be a minimum requirement for any German moves on Eurobonds.

In short, tomorrow’s dinner party is unlikely to yield any tangible results, but it could at least pave the way for a growth compact in June. A growth compact with a clear European flavour, but without giving up on austerity. Unfortunately, we do not know the menu of Herman Van Rompuy’s dinner party tomorrow evening. Still, it seems clear that Van Rompuy will have to find the right balance between tap water and champagne, between the French haute cuisine and German down-home dishes.

Tuesday, May 15, 2012

The German economy has staged an impressive comeback in the first quarter. According to a first estimate of the statistical office, the Eurozone’s biggest economy grew by 0.5% QoQ, from -0.2% in 4Q 2011. Compared with 1Q 2011, this is an increase of 1.7%.

The decomposition of growth will only be released at the end of the month but according to the press statement of the German statistical office and available monthly data, exports should have been the main growth driver. Consumption could have also added to growth, while investment should have been down.

The German economy has escaped the technical recession many other Eurozone countries are currently experiencing with no more than a fright. Looking ahead, with the strong fundamentals, the German economy should remain the stronghold of the Eurozone. However, the stronghold’s immunity against downward trends in most other Eurozone countries is vanishing. The continuous drop in new orders from other Eurozone countries shows that the euro crisis is getting closer. The export engine could spatter sooner than later. Consequently, the future path of the German economy will be increasingly dependent on whether wage increases and the strong labour market can really lead to stronger domestic demand. Not so much for the sake of Eurozone rebalancing but for the sake of German growth. In our view, domestic demand should be strong enough to support growth this year and next year but not beyond. As German exporters are facing global and not only Eurozone competition, a longer period of German wage catching up seems rather unlikely.

With this morning’s numbers, the German economy has not only avoided recession but could have even helped the entire Eurozone economy falling into technical recession. We will know more later this morning. One thing is at least for sure: the German economy remains the powerhouse of the Eurozone economy. Any Eurozone rebalancing still looks like a scenario of a remote future.

Monday, May 14, 2012

Tonight’s Eurogroup meeting could be the prelude of another intensive meeting marathon for the Eurozone, trying to rebalance the crisis management.

When Eurozone finance ministers meet tonight for their regular Eurogroup meeting, they will have a lot to talk about: It is the first meeting after the French and Greek elections, and the first official get-together in the Eurozone’s new discussion on growth versus austerity. Moreover, finance ministers are likely to discuss latest developments in Spain and, more broader, the economic outlook for the Eurozone.

Last week, several European politicians (not only Germans) recalled the need for fiscal consolidation and stressed that the fiscal compact had already been signed by government leaders. In our view, what currently looks like a clash between growth-fanatics and austerity-fetishists will eventually end in a good European compromise with something for everyone: the fiscal compact and the medium-term goal of balanced budgets should remain intact but complemented by a new growth compact with European funds and initiatives. However, even a growth compact can only support but not replace the ongoing structural reforms.

While eventually the discussion on fiscal and growth compacts could turn out to be less controversial than expected, another discussion is more explosive. The discussion on the time path to bring fiscal deficits back to 3% of GDP. Do not forget, this is not part of the new fiscal compact but of existing European Treaties, the so-called Excessive Deficit Procedure (EDP). This year, three countries will have to bring their deficits down to 3%, next year another eight. According to the latest European Commission forecasts, only four countries would currently reach these targets (BE, IT, DE and AT). The crucial issue of the next weeks will now be whether countries will implement additional austerity measures, receive more time or would eventually be sanctioned for not sticking to the rules.

The European rules are not as strict as often believed. While normally the European rules require countries to return their deficits to 3% one year after the identification of an excessive deficit, a loophole in the rules allows for more time in the case of “special circumstances”. These special circumstances were already applied in 2009, giving most Eurozone countries three to four years to reduce their fiscal deficits. Even if the decision on special circumstances is discretionary and not based on a single indicator, one variable to look at when getting an idea of who could again “qualify” for special circumstances is the output gap. According to the latest European Commission forecasts released last Friday, out of all EDP countries, only the Netherlands and Slovenia are expected to have a bigger negative output gap next year than in 2009. In absolute numbers, negative output gaps would be the highest in Slovenia, the Netherlands and Spain.

At the current juncture, decisions on the 3%-adjustment path will require a lot of fine-tuning and sensitivity. While in our view, more time for fiscal adjustment looks almost inevitable and simple to justify for Spain (with a forecasted deficit of 6.3% next year), the challenge is where to draw the line without undermining the credibility of the entire fiscal framework. How to give more time to Spain, while keeping the pressure on countries like France (with an expected deficit of 4.2% in 2013)?

The high level meetings of the coming weeks are likely to shift the balance towards more growth. However, it will not be easy to balance growth, fiscal austerity and credibility. It is obvious the Eurozone policymakers will need a lot of sensitiveness and finesse to succeed.

Thursday, May 3, 2012

At today’s meeting in Barcelona, the ECB left interest rates unchanged. The ECB looks set to keep rates unchanged for a long while. ECB president Draghi’s main message at the press conference could be an inconvenient truth for those hoping for a quick fix of the euro crisis.

The ECB’s macro-economic assessment was almost a verbatim copy of the April meeting. According to the ECB, the economy stabilised in the fourth quarter, albeit at a low level, and economic activity is expected to recovery gradually over the course of the year. Risks to the economic outlook remain to the downside. As regards inflation, the ECB expects headline inflation to stay above 2% in 2012. Probably with German wage negotiations in mind, the ECB still mentions possible signs of second-round effects from higher energy prices. However, in the ECB’s view, risks to the inflation outlook remain broadly balanced.

With a virtually unchanged macro-economic assessment, it did not come as a surprise that according to Draghi the ECB did not discuss rate changes at today’s meeting. As regards the future path of monetary policy, Draghi kept a low profile. In his view, the monetary policy stance was still accommodative. At best, the only two policy-relevant comments were that an exit discussion was premature and that the ECB would decide on the full allotment in its liquidity operations at the June meeting. In our view, clear signals that rates will remain on hold and that ample liquidity operations will remain the ECB’s main policy instrument.

In the absence of essential news on monetary policy, the discussion at today’s press conference was mainly focussed on growth, or better the lack of growth in the Eurozone. Against the background of a further weakening of the Eurozone economy and record high unemployment in many Eurozone countries, the policy and political debate is more and more shifting towards growth. A growth compact has been the new Eurozone buzz word. At today’s press conference, Mario Draghi stressed that a growth compact was not a substitute for fiscal consolidation but rather an addition to austerity measures and structural reforms. In more detail, Draghi’s growth compact should comprise three elements: i) structural reforms in labour and product markets; ii) a revamping of European investment programmes through the EIB or EU funds; and iii) a clear vision for the future of the euro. With a clear call on politicians for a long-term view on the future of the monetary union, Draghi is finally filling the shoes of his predecessor Trichet as the real Mr. Euro.

In our view, Draghi’s call for a growth compact is a plea to politicians, not a hint to further rate cuts. To the contrary, the history of the ECB has shown public pressure on the ECB can be very counterproductive. Remember former ECB president Duisenberg’s saying that central bankers are like cream – the more you whip them, the stiffer they get.

With today’s press conference, Draghi has sent a painful reminder that the ECB cannot solve the current crisis. The ECB will not hesitate to accompany and smoothen this adjustment process but national governments have to be in the lead to do the dirty work. As a result, there does not seem to be any quick fix or alleviation for the economy in the offing. An inconvenient truth.